We Need a Watchdog for all the New Watchdogs

June 11 (Bloomberg) -- Two years after passage of the Dodd-Frank financial reform law, how are we doing putting in place
crucial provisions, including a way to control systemic risk?

Not well, according to Sheila Bair, chairman of the Federal
Deposit Insurance Corp. during the 2008-2009 economic disaster
and author of some of the reforms in the act.

Bair is still at it. On June 6 she established a private-sector systemic-risk council, an initiative funded by the Pew
Charitable Trusts and the Chartered Financial Analysts
Institute. (I’m a member of the council, but I am writing here
in my personal capacity; we have agreed that only Bair will
speak for the council.)

Her point is simple. The Dodd-Frank Act created the all-important Financial Stability Oversight Council (known as FSOC
and pronounced F-Sock). It replaced the President’s Working
Group on Financial Markets, a panel frequently mentioned in
former Treasury Secretary Henry Paulson’s memoir of the
financial crisis, “On the Brink.” That working group lacked
authority to coordinate the alphabet soup of regulators
overseeing the U.S. financial system.

The congressional intent behind this part of Dodd-Frank was
clear: create a council to take charge of
financial stability, put the Treasury secretary in the chair,
and empower a new Office of Financial Research within Treasury
to collect and analyze data on the financial system.

Slower, Cumbersome

None of this organizational structure has worked well in
practice. The result is a much slower and more cumbersome
rulemaking process than intended. “FSOC is M.I.A. OFR is barely
functional. The Volcker Rule is mired in controversy.
Securitization reform is stalled,” Bair told the New York Times.
“The public is becoming cynical about whether the regulators can
do anything right, which is undermining support for reforms.”

Why the stability council has been so ineffective is murky.
Is it lack of enthusiasm on the part of Treasury, opposition
from other regulators, or opposition by large banks? In any
case, Bair is determined to turn up the heat on regulators and
push them to do the job mandated by Congress.

The council is a bipartisan group, with former Democratic
Senator Bill Bradley and former Republican Senators Chuck Hagel
and Alan Simpson. It includes respected former regulators such
as Brooksley Born, ex-Commodity Futures Trading Commission
chairman. Paul Volcker, former chairman of the Federal Reserve,
has agreed to be a senior adviser.

The private sector is also well represented, including Paul
O’Neill, former chief executive officer of Alcoa and former U.S.
Treasury secretary, and John S. Reed, the former Citicorp CEO.

The third group comprises people who, like me, are
academics who have worked in various public policy and private
sector capacities. Ira Millstein, chairman of Columbia Law
School’s Center for Global Markets and Corporate Ownership, will
be the risk council’s legal adviser. The full list of members
can be found here.

As Bair puts it, “The great challenge is to devise a system
to identify risks that threaten market stability before they
become a danger to the general public.”

Persistent Pressure

Putting pressure on officials to implement Dodd-Frank is
relatively straightforward. The council can use polite yet
persistent pressure. This should prove particularly effective
when the group can find a consensus, and my guess is that this
will often be feasible. On bank capital, for example, an
increasing number of well-informed people around the country
insist that big banks need much more equity relative to debt --
that is, bigger buffers against losses. (To be clear, I don’t
know what view the council will take on bank capital and other
specific issues.)

The main obstacle to Dodd-Frank is the powerful bank lobby.
The people who run these banks don’t want to be pushed to become
safer; they like a payoff structure in which they get the upside
when things go well and the downside risk is someone else’s
problem. (Anat Admati of Stanford University and her colleagues
continue to do the clearest work in this area; anyone who
puzzles about these issues should look at her website.)

It surely helps sensible officials to have a well-informed,
articulate group of outsiders pushing them from the other
direction -- against the special interests.

A more difficult task is to measure and comprehend system
risks before they become debilitating. That’s what the Office of
Financial Research is supposed to do. It shouldn’t just report
on current credit conditions in a generic fashion; it should
coordinate the release of timely information from all parts of
the financial system.

There may be alternatives to building up a strong and
independent-minded OFR, but I don’t see them. I don’t see any
chance that the Federal Reserve or other regulators will share
the data needed to anticipate risks.

For example, how should we measure the current exposure of
our financial system to the sovereign and banking crisis in
Europe? What is the right way to think about the potential
losses that could be incurred through the derivative positions
of very large banks? How should we think about international
counterparty risks when it is European sovereigns -- not just
their banks -- that are under severe pressure?

Our ability to ensure financial stability is only as good
as the available data. I’m concerned that, when the next
financial crisis hits, the OFR will be the weakest official
link. Thinking about how to strengthen that office is an
important priority for anyone who cares about systemic risk. If
you have specific ideas, send them along.

(Simon Johnson, a professor at the MIT Sloan School of
Management as well as a senior fellow at the Peterson Institute
for International Economics, is a co-author of “White House
Burning: The Founding Fathers, Our National Debt, and Why It
Matters to You.” The opinions expressed are his own.)

Today’s highlights: The editors on why boring banking isn’t
safer and on voter registration in Florida; Mark Buchanan on
testosterone and trading; William D. Cohan on watering down
Dodd-Frank; Albert R. Hunt on November election milestones;
Pankaj Mishra on the growing capitalism-democracy split; William
Pesek on Greece’s effect on Asia; Red Jahncke on a German exit
from the euro; Jay S. Fishman on how to incubate small
businesses.